THE RECENT FINANCIAL CRISIS Professor Lawrence Summers October 6, 2015 Ec 10

Agenda From last time: National Income Accounting The Great Recession Why do crises like the Great Recession happen?

Trade Balance = Saving - Investment National income identity: Y = C + I + G + X – M Rearranged: (Y – C – G) – I = X – M Total national saving is output minus consumption and government spending: S = Y – C – G So: S – I = X – M National Saving – National Investment = Trade Balance

Agenda From last time: National Income Accounting The Great Recession Why do crises like the Great Recession happen?

GDP growth still limited GDP has fallen sharply relative to the economy’s potential; here’s real GDP and the CBO’s estimate of potential GDP before the crisis.

GDP growth still limited GDP has fallen sharply relative to the economy’s potential; here’s real GDP and the CBO’s estimate of potential GDP over time.

Employment still lagging Employment ratio dropped during recent recession and has barely increased

Employment still lagging Employment ratio dropped during recent recession and has barely increased

Agenda From last time: National Income Accounting Money: why does it exist? How does it relate to prices? The Great Recession Why do crises like the Great Recession happen? What can be done about them? Global consequences

Recap: function of financial markets

(1) Win $1 if ALL play A, lose $10 otherwise (2) Win $1 if MORE THAN 90% play A, lose $10 otherwise (3) Win $1 if MORE THAN 80% play A, lose $10 otherwise What does the 80% signify? Recap: bank run game

Bank runs Classic bank run, 1931 Modern bank run happens instantaneously with use of computer technology

Deposit run on a bank Liability run when collateral value is questioned Uncertainty about ability to defend a currency Race to the exit in an asset market Contagion  Banks with similar loan portfolios look the same to depositors, so if one becomes insolvent, the others are questioned Bank Run Effects What exactly happens when there is a bank run? Bank starts paying off depositors by selling liquid assets (those that are easy to turn into cash) Next, fire-sale of non-liquid assets can mean selling at low values Bank even more insolvent – assets worth less relative to liabilities

Normal Economics: Negative Feedback Negative feedback: self-equilibrating system. Deviations from equilibrium are self-correcting Analogies Thermostat Ball in bowl Examples Supply and demand

Normal Economics: Negative Feedback Negative feedback: self-equilibrating system. Deviations from equilibrium are self-correcting Analogies Thermostat Ball in bowl Examples Supply and demand

Crisis Economics: Positive Feedback Positive feedback: Deviations from equilibrium perpetuate themselves Analogy: Ball on bowl Further it falls, faster it travels from initial position

Crisis Economics: Positive Feedback Positive feedback: Deviations from equilibrium perpetuate themselves Analogy: Ball on bowl Further it falls, faster it travels from initial position

$400 loss The creation of leverage Without leverage, when you invest, your return is determined by the asset price. Borrowing enables you to create leverage, so your return is a multiple of the change in the asset price. Example: you buy $1000 of stock Case 1: no leverage $600 (a) Stock rises by 40% (b) Stock falls by 40% $1,000 in cash $1000 equity +$400 equity 40% return $600 equity 40% loss $600 loss $400 (c) Stock falls by 60% $400 equity 40% loss $1,000 $1,400

The creation of leverage $1,000 $1,400 $600 (a) Stock rises by 40% (b) Stock falls by 40% $500 debt +$400 equity $400 (c) Stock falls by 60% $500 cash $500 debt $500 equity $500 debt Case 2: 50% leverage 80% return 80% loss Negative equity: debt -$500. assets +$400 $400 loss $600 loss $100 equity left All equity gone Borrowing enables you to create leverage. This enhances your possible return, but also your risk. And it creates risk for the lender To mitigate this risk, lenders (usually brokers) often have a “margin requirement” $1,000

Leveraged investor’s equity falls Broker makes “margin call”: investor required to deposit additional funds Investor forced to sell stock to do so Stock sales put downward pressure on stock price Company A stock falls Leverage can lead to cascading selling Background: what is a margin call? Brokers often require a “maintenance margin” to be deposited by leveraged investors. This is a certain % of the total security value. It is designed to reduce the risk of the broker. If the security price falls below a threshold, the broker makes a “margin call”, requiring the investor to deposit more funds.

Elements of positive feedback during crisis 1.Liquidations driving prices down 2.Asset price decline hit bank capital 3.Financial strains exacerbate economic problems 4.Keynesian multiplier effects 5.Deflationary spiral 6.Fear raises borrowing costs